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Derivatives for Dummy

Derivatives for Dummy

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Published by KH Tang
A simple story to illustrate how the complex derivative markets work.
A simple story to illustrate how the complex derivative markets work.

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Published by: KH Tang on May 05, 2010
Copyright:Attribution Non-commercial

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05/12/2014

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A friend had forwarded me a very interesting story that illustrates how the derivative markets createdthe bubbles. (I was told the author is an accountant, but don't know the author's name.)
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Explanation of Derivative Markets
 
Heidi is the proprietor of a bar in Detroit. She realizes thatvirtually all of her customers are unemployed alcoholics and,as such, can no longer afford to patronize her bar. To solvethis problem, she comes up with a new marketing plan thatallows her customers to drink now, but pay later.
 
Heidi keeps track of the drinks consumed on a ledger(thereby granting the customers' loans). Word gets aroundabout Heidi's "drink now, pay later" marketing strategy and,as a result, increasing numbers of customers flood intoHeidi's bar. Soon she has the largest sales volume for any barin Detroit.
 
By providing her customers freedom from immediate paymentdemands, Heidi gets no resistance when, at regular intervals,she substantially increases her prices for wine and beer, themost consumed beverages. Consequently, Heidi's gross salesvolume increases massively.
 
A young and dynamic vice-president at the local bankrecognizes that these customer debts constitute valuablefuture assets and increases Heidi's borrowing limit. He seesno reason for any undue concern, since he has the debts ofthe unemployed alcoholics as collateral.
 
 
At the bank's corporate headquarters, expert traders figurea way to make huge commissions, and transform thesecustomer loans into DRINKBONDS, ALKIBONDS andPUKEBONDS. These securities are then bundled and tradedon international security markets.
 
Naive investors don't really understand that the securitiesbeing sold to them as AAA secured bonds are really the debtsof unemployed alcoholics. Nevertheless, the bond pricescontinuously climb, and the securities soon become thehottest-selling items for some of the nation's leadingbrokerage houses.
 
One day, even though the bond prices are still climbing, a riskmanager at the original local bank decides that the time hascome to demand payment on the debts incurred by thedrinkers at Heidi's bar. He so informs Heidi.
 
Heidi then demands payment from her alcoholic patrons, butbeing unemployed alcoholics they cannot pay back theirdrinking debts. Since Heidi cannot fulfill her loan obligationsshe is forced into bankruptcy. The bar closes and the elevenemployees lose their jobs.
 
Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDSdrop in price by 90%. The collapsed bond asset value destroysthe banks liquidity and prevents it from issuing new loans, thusfreezing credit and economic activity in the community. Thesuppliers of Heidi's bar had granted her generous paymentextensions and had invested their firms' pension funds in the

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